FIN 401 MC Questions Final

A company's weighted average cost of capital:

is the return investors require on the total assets of the firm.

Agency Problem Solutions

managerial compensation tied to stock performance threat of takeover institutional ownership

liquidity premium

the portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity

Compouding

the process of earning interest on interest

Capital Budgeting

the process of planning and managing a firm's long-term investments

Which one of the following best illustrates that the management of a firm is adhering to the goal of financial management?

An increase in the market value per share

Which one of the following compounding periods will yield the lowest effective annual rate given a stated future value at Year 5 and an annual percentage rate of 10 percent?

Annual

Optimal Capital Structure

Best debt to equity ratio for a firm that maximizes its value OCS is one that balances between the ideal debt to equity range and minimizes the firm's cost of capital

capital structure:

How a firm finances its overall operations and growth by using different sources of funds Best to choose a structure that will maximize shareholder wealth/value Can be a mixture of long-term debt, short-term debt, common equity and preferred equity

The stand-alone principle advocates that project analysis should be based solely on which one of the following costs?

Incremental

Capital Restructuring:

Involves changing the amount of leverage a firm has without changing the firm's assets only changes the mixture of debt and equity Increase leverage by issuing debt and repurchasing outstanding shares Decrease leverage by issuing new shares and retiring outstanding debt Optimizes profitability or responds to a crisis like bankruptcy, changing market conditions, etc

During the year, Al's Tools decreased its accounts receivable by $160, increased its inventory by $115, and decreased its accounts payable by $70. How did these three accounts affect the sources of uses of cash by the firm?

Net use of cash of $25

The option that is forgone so that an asset can be utilized by a specific project is referred to as which one of the following?

Opportunity Cost

The items included in an indenture that limit certain actions of the issuer in order to protect a bondholder's interests are referred to as the:

Protective covenants

ideal financial leverage

ROE increases b/c leverage increases stock volatility, increasing its level of risk which increases returns

Preferred source of financing according to pecking order theory

Retained earnings Debt Common Stock

Frank's is a furniture store that is considering adding appliances to its offerings. Which one of the following is the best example of an incremental cash flow related to the appliances?

Selling furniture to appliance customers

Which one of the following statements related to the internal rate of return (IRR) is correct?

The IRR is equal to the required return when the net present value is equal to zero.

accounting insolvency

book value of equity is negative

unsystematic risk

can be effectively eliminated by portfolio diversification.

Price Risk

change in price due to changes in interest rates

Agency problems are most associated with:

corporations.

Which is generally true about the cost of equity and the cost of debt?

cost of equity may increase with leverage cost of debt is generally lower than cost of equity cost of debt increases with leverage

Networking Capital (NWC)

current assets - current liabilities

M&M case 3 static theory

debt is beneficial up to a certain borrowing point; too much debt is bad especially when earnings dec.; could lead to bankruptcy; OCS under this case is when max tax benefit from interest deductibility is balanced with cost of financial distress that comes from inc. debt. WACC is at its lowest point, mix of debt/equity is optimal

Ignoring bonus depreciation, the net book value of equipment will:

decrease slower under straight-line depreciation than under MACRS.

technical insolvency

firm is unable to meet debt obligations

pecking order

firm will choose to use internal financing to cover cash outflows before they choose to issue debt; sell equity as last resort; no target capital structure; will invest inflows so they can sell later to cover outflows

A business formed by two or more individuals who each have unlimited liability for all of the firm's business debts is called a:

general partnership

A "fallen angel" is a bond that has moved from:

investment grade to speculative grade

Change in NWC

investment in NWC is reversible Investment in NWC is cash outflow (increase is outflow, decrease in inflow)

The average accounting rate of return is:

is similar to the return on assets ratio.

Limitations of Ratio Analysis

*Not useful when viewed in isolation *Skewed by different accounting treatments *Difficult to find appropriate ratios when companies compete in multiple industries *Conclusions can't be made by looking a a single ratio *Determining a target or comparison value of a ratio is difficult *globalization *no underlying theory *varying accounting methods

procedure for corporate valuation

1. forecast fin stat 2. est the projected fcf and its growth rate 3. calc the value of operations using disc cf model 4. calc the total corp value and the value of common equity

annuity due

An annuity that pays at the beginning of each period.

ordinary annuity

An annuity that pays at the end of each period.

Two-Stage Dividend Growth Model

A dividend discount model that assumes a firm will temporarily grow at a rate different from its long-term growth rate.

Beta

A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

Net Present Value (NPV)

A method of ranking investment proposals using the NPV, which is equal to the present value of the project's free cash flows discounted at the cost of capital.

Markowitz mean-variance portfolio model

A portfolio optimization model used to construct a portfolio that minimizes risk subject to a constraint requiring a minimum level of return.

Maturity Risk Premium (MRP)

A premium that reflects interest rate risk; bonds with longer maturities have greater interest rate risk.

Which one of the following statements is correct?

A project can create a positive operating cash flow without affecting sales.

WACC

A weighted average of the component costs of debt, preferred stock, and common equity.

Corporate Assets

All intangible items (corporate goodwill, company name, company logo, etc.) and tangible items (buildings, property, etc.) owned by the corporation

Corporate Valuation Model

Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm's free cash flows.

You are comparing two annuities that offer regular payments of $2,500 for five years and pay .75 percent interest per month. You will purchase one of these today with a single lump sum payment. Annuity A will pay you monthly, starting today, while annuity B will pay monthly, starting one month from today. Which one of the following statements is correct concerning these two annuities?

Annuity B has a smaller present value than annuity A.

debt-irrelevance proposition

As long as investors can borrow or lend on their own account on the same terms as the firm, they are not going to pay more for a firm that has borrowed on their behalf. The value of the firm after the restructuring must be the same as before. In other words, the value of the firm must be unaffected by its capital structure.

Christina invested $3,000 five years ago and earns 2 percent annual interest. By leaving her interest earnings in her account, she increases the amount of interest she earns each year. The way she is handling her interest income is referred to as:

Compounding

MM1

Concerns VALUE of company. Without Tax- It does not matter. Capital Structure Irrelevence With Tax- Value is maximized with 100% debt because of Tax Shield

Which business form is best suited to raising large amounts of capital?

Corporation

Cost of Financial Distress

Costs arising from bankruptcy or distorted business decisions before bankruptcy

Which one of the following relationships applies to a par value bond?

Coupon rate = Current yield = Yield to maturity

Terry is calculating the present value of a bonus he will receive next year. The process he is using is called:

Discounting

Dividend Discount Model

Discounted cash-flow model which states that today's stock price equals the present value of all expected future dividends

Which one of the following sets of dividend payments best meets the definition of two-stage growth as it applies to the two-stage dividend growth model?

Dividend payments that increase by 10 percent per year for five years followed by dividends that increase by 3 percent annually thereafter

Breakeven EBIT formula

EBIT/Shares = EBIT - Interest / Shares

sustainable growth

Economic growth that meets current needs but conserves resources for the future

factors that impact default risk premium

Financial performance bond contract provisions

Working Capital Management

Management of a firm's current balance of assets and liabilities (short-term asset and liability); involves accounts payable and receivable, inventory and cash.

M&M Case 1, Proposition 1

Market value of a firm is independent of capital structure; Value of levered firm = value of unlevered firm; considers a firm with no taxes; total book value stays the same regardless of Cap. Str.; cost of equity incr. when debt incr. but is offset by the change in weight distribution of D/E. WACC will not change

Goal of Financial Management

Maximize the current value per share of the company's existing stock Maximize the market value of the existing owners' equity

Which one of the following is a project acceptance indicator given an independent project with investing type cash flows?

Modified internal rate of return that exceeds the required return

A project has an initial cost of $31,800 and a market value of $29,600. What is the difference between these two values called?

Net Present Value

The profitability index is most closely related to which one of the following?

Net Present Value

Which one of the following methods predicts the amount by which the value of a firm will change if a project is accepted?

Net Present Value

Steve has invested in twelve different stocks that have a combined value today of $121,300. Fifteen percent of that total is invested in Wise Man Foods. The 15 percent is a measure of which one of the following?

Portfolio Weight

Kurt won a lottery and will receive $1,000 a year for the next 50 years. The current value of these winnings is called the:

Present Value

The present value of an investment's future cash flows divided by the initial cost of the investment is called the:

Profitability index

GL Plastics spent $1,200 last week repairing a machine. This week the company is trying to decide if the machine could be better utilized if they assigned it a proposed project. When analyzing the proposed project, the $1,200 should be treated as which type of cost?

Sunk Cost

Breakeven EBIT

The level of EBIT that makes EPS and ROE the same both without debt and with a proposed level of debt

Discounting

The process of finding the present value of a cash flow or a series of cash flows; discounting is the reverse of compounding.

A project has a net present value of zero. Which one of the following best describes this project?

The project's cash inflows equal its cash outflows in current dollar terms.

Homemade leverage

The use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed.

CAPM (Capital Asset Pricing Model)

Theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium

financial markets

Transfer funds from savers to borrowers

Corporation Advantages

Unlimited life Easy transfer of ownership Limited liability Ease of raising capital

deferred call

a bond provision stating that the bond can't be called until a set number of years have passed since it was issued

business failure

a business that has stopped operating with a loss to creditors

The decision to issue additional shares of stock is an example of:

a capital structure decision.

All else constant, a bond will sell at _____ when the coupon rate is _____ the yield to maturity.

a discount; less than

Capital Structure

a firm's mix of debt and equity financing

Constant Growth DDM

a form of the dividend discount model that assumes dividends will grow at a constant rate

A stock with an actual return that lies above the security market line has:

a higher return than expected for the level of risk assumed.

Security Market Line (SML)

a positively sloped straight line displaying the relationship between expected return and beta

correlation coefficient

a statistical measure of the extent to which two factors vary together, and thus of how well either factor predicts the other (+1,0,-1)

perpetuity

a time period lasting through the ages; eternity

A project's average net income divided by its average book value is referred to as the project's average:

accounting return

Which is more relevant, the pretax or the aftertax cost of debt?

aftertax cost of debt

call provision

agreement giving the issuer the option to repurchase a bond at a specific price prior to maturity helps issuer, hurts investor

Effect of Leverage

amplifies the variation in both Earnings Per Share and Return on Equity

Protective covenants:

are primarily designed to protect bondholders

Corporation Disadvantages

double taxation

One disadvantage of the corporate form of business ownership is the:

double taxation of distributed profits.

The primary purpose of portfolio diversification is to:

eliminate asset-specific risk.

DuPont Identity

expresses return on equity as the product of profit margin, asset turnover, and a measure of leverage

as iy __, PV __

increase, decrease

as market iy __, bond price __

increase, decrease

as iy __, FV __

increase, increase

If EBIT __, EPS __.

increases, increases

WACC measures

indicates whether we should accept a project or not must be positive irr>wacc to be accepted

Systematic Risk

market risk, non-diversifiable

An increase in EPS means the company's EPS is __.

more volatile

primary market

new-issue market

M&M case 2

optimal cap. Str. Is through 100% debt; when corporate taxes are considered, the value of a levered firm with debt exceeds value of unlevered firm by the amount of its tax benefit.; also uses 100% debt using WACC; WACC dec. when debt inc. (positive outcome); interest paid on debt is tax deductible

legal bankruptcy

petition federal court for bankruptcy

secondary market

previously issued securities are traded among investors

private placement

primary offerings in which shares are sold directly to a small group of institutional or wealthy investors

Shareholders' equity:

represents the residual value of a firm

The dividend growth model:

requires the growth rate to be less than the required return.

incremental cash flows

the additional cash flows—outflows or inflows—expected to result from a proposed capital expenditure.

Free Cash Flow (FCF)

the amount of cash flow available to investors (creditors and owners) after the firm has met all operating needs and paid for investments in net fixed assets and net current assets

In the absence of taxes, the value of a firm is the same with debt financing as it is with equity financing because?

the asset to be financed is the same MM demonstrated that debt financing is neither better nor worse than equity financing in the absence of taxes.

stand-alone principle

the assumption that evaluation of a project may be based on the project's incremental cash flows

WACC without taxes

the change in the capital structure weights (E/V and D/V) is exactly offset by the change in the cost of equity, so the WACC stays the same.

Internal Rate of Return (IRR)

the discount rate that makes the NPV of an investment zero

financial risk

the equity risk that comes from the financial policy (the capital structure) of the firm (amount of leverage)

Business Risk

the equity risk that comes from the nature of the firm's operating activities

Cash Conversion Cycle (CCC)

the length of time funds are tied up in working capital, or the length of time between paying for working capital and collecting cash from the sale of the working capital

Working capital management decisions include determining:

the minimum level of cash to be kept in a checking account

cost of capital

the rate of return a company must earn in order to meet the demands of its lenders and expectations of its equity holders

Fisher effect

the relationship between nominal returns, real returns, and inflation

The discount rate assigned to an individual project should be based on:

the risks associated with the use of the funds required by the project.

Static Theory of Capital Structure

the theory that a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress

financial leverage

the use of borrowed funds for direct investment purposes

Extended Pie Model

the value of all the claims against the firms cash flows is not affected by capital structure, but the relative value of claims change as the amount of debt financing is increased; considers corporate taxes and claims of the firm (bankruptcy, shareholder, etc.); cash flows are the sum of the claims

reinvestment rate risk

uncertainty surrounding the cumulative future value of reinvested bond coupon payments

public offering

uses investment bank

You cannot attend the shareholder's meeting for Alpha United so you authorize another shareholder to vote on your behalf. What is the granting of this authority called?

voting by proxy

An example of a capital budgeting decision is deciding:

whether or not to purchase a new machine for the production line.